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A Dual Approach to Contract Remedies Michael D YALE LAW & POLICY REVIEW A Dual Approach to Contract Remedies Michael D. Knobler* INTRODUCTION ................................................................. 416 I. VALUE-BASED THEORY: THE CONTRACT AS OPTION...... ............... 418 A. Economic Efficiency. ............................ .......... 419 B. Contract-Law Rules....................................420 II. PERFORMANCE THEORY: THE CONTRACT AS COMMITMENT ...................... 424 A. How Performance Theorists React to Breach ............. ...... 425 B. Societal Expectations ................................... 427 C. The Deal to Which PartiesActually Consented, and Why That Matters ................................... ........ 433 D. The Search for a Middle Ground. ........................... 441 III. How COURTS TACKLE THE QUESTION .................................... 444 A. Bad-Faith Breach................ ..................... 444 B. Diminution in Value vs. Cost of Completion......................447 IV. POTENTIAL SOLUTIONS: WHY BIFURCATING REMEDIAL APPROACHES MAKES SENSE .............................................................. 448 A. Doing Nothing ....................................... 449 B. Notice .............................................. 449 C. Remedies Under a Performance Theory... ............................ 450 D. CreatingDual Systems.................................. 453 i. How Contract Law Already Tailors Itself to Parties' Needs.........453 2. Where To Apply the Option and Performance Theories.............456 3. Should the System of Remedies Be Contractible?.........................457 CONCLUSION ............................................ .......... ...................... 459 Yale Law School, J.D. expected 2012; Harvard University, A.B. 1985. I would like to thank Professors Rick Brooks, Greg Klass, and Daniel Markovits, Notes Editor Al- exandra Roth, and Daniel Hemel, Talia Kraemer, Robert Leider, Alex Platt, David Robinson, and Ellen Weis for their valuable comments. 415 YALE LAW & POLICY REVIEW 30:415 2012 INTRODUCTION Numerous disagreements in contract law stem from the answer to a straightforward definitional question: What is a contract? Is it a mutual com- mitment to perform, or is it merely a promise to deliver the agreed-upon per- formance or pay damages, with each choice treated as equally acceptable? Is a contract about the right to obtain an agreed-upon good or service at a given time, or is it about the right to obtain an agreed-upon value at a given time?' Most people answer those questions differently than the law does. People overwhelmingly view breach as immoral, favor specific performance if breach occurs, and consider exclusively economic damages undercompensatory.' In contrast, courts typically treat breach as a rational option and deny nonbreach- ing parties specific performance and both nonpecuniary and punitive damages.3 The courts' approach seems targeted to the needs of businesses rather than in- dividuals. 4 This disconnect between most people's beliefs and court enforcement un- dermines a foundational claim of contract law, that parties consent to a set of rules to guide their conduct and that courts enforce the parties' will.' Contract law zealously protects this consent principle in other areas, such as the statute of frauds, the doctrine of unconscionability, and the requirement for objective 1. Compare Louis KAPLOW & STEVEN SHAVELL, FAIRNESS VERSUS WELFARE 155-224 (2002) (arguing that the option to breach and pay damages maximizes social wel- fare), Oliver Wendell Holmes, Jr., The Path of the Law, io HARV. L. REV. 457, 462 (1897) ("The duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it-and nothing else."), and Richard Pos- ner, Let Us Never Blame a Contract Breaker, 107 MICH. L. REV. 1349 (2009) (sup- porting the option theory), with Bailey v. Alabama, 219 U.S. 219, 246 (1911) (Holmes, J., dissenting) ("Breach of a legal contract without excuse is wrong con- duct...."), Seana Shiffrin, Could Breach of Contract Be Immoral?, 107 MICH. L. REV. 1551 (2009) [hereinafter Shiffrin, Breach] (arguing for a perfor- mance-oriented approach), and Seana Valentine Shiffrin, The Divergence of Con- tract and Promise, 120 HARV. L. REV. 708 (2007) [hereinafter Shiffrin, Divergence] (same). 2. See infra Section II.B. 3. See infra Section I.B. 4. See infra Part I. 5. See Bidlack v. Wheelabrator Corp., 993 F.2d 603, 612 (7th Cir. 1993) (Cudahy, J., concurring) ("When the parties or the situation are such that those affected by the rule cannot bargain around it ... the rule may, in effect, supply terms to which the parties are bound but to which they have not explicitly agreed. In these cir- cumstances, courts should try to select the default rule that best reflects the course the parties would have taken had they bargained freely.") (citing FRANK H. EASTERBROOK & DANIEL R. FISCHEL, THE ECONOMIC STRUCTURE OF CORPORATE LAW 15 (1991); RICHARD POSNER, EcONOMic ANALYSIS OF LAW 372 (3d ed. 1986)). 416 A DUAL APPROACH TO CONTRACT REMEDIES manifestations of intent.6 It seems incongruous, therefore, to frustrate consent when choosing remedies for breach. This Note does not choose sides in the decades-old value versus perfor- mance dispute. Instead, it suggests a both-and answer for a question to which others have given an either-or response. Rather than saying that all contracts are mutual commitments to perform, or that all contracts are merely promises to deliver the agreed-upon performance or pay damages, why not recognize that the idea of "contract" embraces both definitions? Some contracts fit in one cat- egory, some in the other. Just as the Uniform Commercial Code (UCC) sets forth different rules for contracts among merchants and for those among other parties,7 so contract law in general should-and perhaps does-recognize the differing expectations and understandings of different contractors. If business people typically contract for value and consumers typically contract for perfor- mance, the law should be tailored to reflect that difference. This conclusion follows whether one wishes contract law to maximize au- tonomy or efficiency. Not only does an exclusively option-oriented approach to contracts frustrate the will of those who wish to contract for performance, it al- so creates party error, which is a gap between the contract as understood by at least one of the parties and the contract as enforced by the courts.9 Party error leads to inefficient contracts.o Only by abandoning the one-size-fits-all ap- proach can contract law maximize both efficiency and autonomy. I suggest two systems of remedies: a performance-oriented one for con- tracts to which at least one individual is a party and an option-oriented one for contracts involving only businesses. The performance-oriented approach would make more liberal use of specific performance and would make damages reme- dies more fully compensatory of both economic and nonpecuniary harms. The option-oriented approach would look much like current contract law, with its focus on compensating economic harms. 6. See infra notes 113-120 and accompanying text. 7. See, e.g., U.C.C. §§ 2-201(2), 2-205, 2-207(2), 2-209(2), 2-605(1)(b), 2-609(2) (1977). 8. See Ian Ayres & Robert Gertner, Filling Gaps in Incomplete Contracts:An Economic Theory of Default Rules, 99 YALE L.J. 87, 91 (1989) (defining a "tailored default" as a rule that attempts to provide parties "what they would have contracted for"); cf Hanoch Dagan, Pluralism and Perfectionism in Private Law 17 (Nov. 12, 2011) (unpublished manuscript) (on file with author) ("[D]espite the appeal of mon- ism's global coherence, value pluralism makes it reasonable and even desirable for law to adopt more than one set of principles and, therefore, more than one set of coherent doctrines."). 9. For a discussion of party error, see Ian Ayres, Regulating Opt-Out: An Economic Theory of Altering Rules, 121 YALE L.J. 2032 (2012). 10. See infra Section II.B. 417 YALE LAW & POLICY REVIEW 30:415 2012 This Note proceeds in four parts. Part I describes the efficiency justifica- tions for the option theory and shows that many rules of current contract law reflect this approach. Part II describes the theory that contracts constitute moral commitments, examines empirical data revealing how well that theory matches ordinary people's understandings, and argues that a law of contracts that ig- nores those understandings violates the fundamental requirement that con- tracts be consensual. Part III analyzes case law to show how this central ques- tion-is contract about performance or value?-plays out in the doctrine of bad-faith breach and in the choice of remedies between cost of completion and diminution in value. Part IV analyzes potential responses to the problems creat- ed by the duality of contract theory and suggests bifurcating contract-law reme- dies along the performance versus value divide. I. VALUE-BASED THEORY: THE CONTRACT AS OPTION The prevailing economic view of contract law focuses on its role as the fa- cilitator of voluntary exchanges, presumed to be welfare-enhancing." Transac- tions that result in gains from trade should be encouraged, according to this theory, as parties' self-interest will make contractual exchanges Pareto efficient, leaving at least one party better off and neither worse off." Sometimes, though, the parties will discover after formation that performance would be more costly to the promisor than value-producing for the promisee. In such a situation, performance would
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